Commodity Producing Countries:
Ramping-Up Hedging Programmes Economic growth and the general level of macroeconomic activity in many commodity producing countries is tightly linked to movements in energy, commodity and financial markets prices. In this article we explore the political and economic implications of alternative hedging strategies and present a series of risk metrics that can assist with the design, management and communication of hedging programmes.
By Carlos Blanco SURPRISINGLY FEW COUNTRIES have
traditionally hedged their production revenues, despite the wide negative repercussions of adverse market shocks. Recently, more countries are taking an active approach to manage production revenues to ensure greater financial stability.
The Case For HedgingProductionRevenues Many emerging economies rely heavily on
production sales revenues to fund public works infrastructure projects, as well as essential services such as education and health. However, given the large fluctuations in energy and commodity prices as well as the uncertainty around their production volumes, those countries are often exposed to external shocks outside their control.
Figure 1. Brent Crude Prices & Y-o-Y Changes
120 150
30 60 90
-90 -60 -30 0
Source: NQuantX Governments can reduce budget uncertainty as a
result of price volatility by ‘hedging’ their revenues using financial instruments such as swaps and options. Hedging mainly consists on transferring those risks to other financial market participants in exchange of more predictable cash flows. Due to the high volatility of energy and commodity
prices in recent years (see Figure 1), governments face more pressure to evaluate alternative strategies to mitigate price risk and reduce disruptions caused by negative market moves.
86 December 2012
Europe Brent Spot Price FOB (USD/bbl) Change Y-0-Y
There are three main types of hedging strategies:1
A. Not hedging is in itself a strategy that makes revenues vulnerable to adverse world energy and commodity market developments.
B. Locking in revenues by fixing sales prices. Strategies include physical and financial swaps, futures, and costless collars.
C. Buying insurance by paying a premium to protect against potential price declines. Strategies include put options and put spreads.
Traditionally, many governments have made
the argument that the most ‘conservative’ option was not to use derivatives. In some instances, laws were passed that banned the use of derivatives instruments, which left government revenues being fully exposed to market forces outside their control. However, this argument is highly flawed,
and misses the point that hedging can bring greater macroeconomic stability through more predictable government policies, as well as more stable exchange rates and lower borrowing costs. There are strong economic arguments why the default choice for producing countries that want to be conservative would be to hedge their revenues. From a political point of view, the
arguments for and against hedging are more complex. In many instances, the default option is not to hedge to avoid the political fallout from having to explain the potential losses that the hedging
programme may experience. A recent example clearly illustrates this point. The state of Alaska reviewed alternative options to hedge oil revenues, and concluded that “some policy makers will be reluctant to take the political risks of a hedging program. If a program succeeded, it is unlikely the policy makers who took the initiative to create the program would be rewarded with public congratulations. On the other hand, if the state lost significant sums…, the conventional wisdom is that public criticism would be harsh.”2
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